The last several months since the election have been interesting, to say the least. Stocks have rallied to all-time highs, volatility seems to be nearly non-existent, and some investors seem to think there’s nowhere to go from here but up. And yet, one could also argue that this has been one of the most “boring” years so far in recent memory. Since the beginning of the year, the stock market has seen only four trading days with a 1% move (up or down), and zero days with a move of 2% or more. That’s not to say we are necessarily due for more volatility ahead, but it certainly highlights the eerie steadiness of the market so far this year.
We have heard many investors characterize the rally since the election as the “Trump Bump,” but scratch beneath the surface and you can see that 2016 and 2017 were actually two very different markets. The chart below exhibits the difference we have seen between value stocks (characterized by companies in the Russell 1000 Index that exhibit lower valuations) and growth stocks (characterized by companies in the Russell 1000 Index that rank higher on historical sales growth and forecasted growth) between 2016 and year-to-date 2017.
For the calendar year 2016, the Value Index posted a return of more than ten percentage points higher than that of the Growth Index, highlighting the outperformance of companies with strong fundamentals. Dividend-paying and traditional value stocks led the way for most of the year, especially post-election as the market attempted to digest the implications of a Trump presidency. Hopes of economic expansion, the anticipation of pro-growth policies and lower corporate tax rates, and a predicted increase in inflation all drove the market higher.
While enthusiasm from the election certainly carried over into 2017, the expectations for reform and economic growth have begun to stall, causing investors to instead turn their focus on to higher beta, momentum driven stocks in their search for growth. This has caused the market to make a nearly 180 degree turn from last year, with companies in the Growth Index now returning three times the Value Index so far this year. By itself, this is not worrisome; market leadership often changes from year to year. More concerning to us, however, is that a very small number of stocks are driving most of this year’s performance.
The S&P 500 Index consists of 508 individual companies, and yet at the time of the writing of this article, ten of these companies are making up to roughly 30% of its return this year. On top of that, most of these are technology stocks, a sector which now makes up 22% of the S&P 500 (a weighting last seen in 2001). This means that for the other 498 stocks in the S&P 500, most are lagging behind or even negative for the year. Surprisingly, companies which exhibit high earnings quality and attractive valuations have actually been the worst performers this year by far.
What exactly does all of this mean for your portfolio? At Doyle Wealth Management, our focus has always been on investing in companies that offer the highest probability of future outperformance through a combination of financial strength, high cash flow generation, growing dividends, and improving dynamics. Perhaps more importantly, however, we are committed to remaining disciplined in our approach even when it becomes tempting to follow the trends of the market. To us, capital preservation is just as important as potential reward, and one of the most important ways to protect your money is to be keenly aware of valuation.
One stock our clients often ask about is Amazon, which is one of the aforementioned ten stocks currently leading the stock market. Anyone who has invested in the company is surely happy with the returns they have seen in the last several years. If you dig a little deeper, however, Amazon’s earnings have only actually become profitable in the last two years, and the company trades at around 180 times its trailing earnings per share (EPS). In other words, at its current price, the market is saying that it expects Amazon to continue to grow its earnings per share at nearly 50% per year going forward. Could Amazon accomplish and sustain that kind of growth? Anything is possible, but it’s not a bet that makes sense to us. By comparison, companies that we feel represent attractive value currently average closer to 19 times earnings.
How long can a market trend like this last? No one knows for sure. But, ultimately, stock prices follow earnings, and we remain steadfast in our commitment to investing in attractively priced, high quality companies that we believe can weather both good markets and bad. And in the meantime, we have made sure our seatbelts are fastened.
